Mark, with market conditions where they are, things are looking pretty good, what should hedge funds be doing now in case of a potential downturn?

MARK ALDOROTY, MANAGING DIRECTOR, HEAD OF PRIME SERVICES, PERSHING: I think you always want to be prepared before any disruption or dislocation, just change or pivot in the marketplace. While managers spend time focusing on their risk metrics, the question is, do they also focus on their liquidity and their financing needs? Do they understand where in the world their assets are?

One wants to be prepared before anything might happen to understand the potential differences in the liquidity of their portfolio versus the redemption cycle of their investors versus the funding they have lined up with their financing counterparts, such as prime brokers.

In addition to that, they may want to look at some of their legal agreements to understand where in the world are my assets? What’s been rehypothecated? What actually stays with the prime broker? What are the prime broker rights? What are their rights? And also make sure they have the right connectivity. You may almost want to come together with a break-the-glass plan. That is, if something should go wrong, it’s not the time to figure out what the next steps are. That’s the time you need in advance to figure out how to lay that out and what you need to do.

LYDIA TOMKIW: And as part of that break-the-glass plan or emergency plan, what should be the main components and what are the possible market conditions you should be planning for when you’re making one or considering it?

MARK ALDOROTY: The first thing, again, you’ve already managed your market risk, now you have to worry about your counterparty risk. Do you have a term agreement with your prime broker? Will you be able to move your positions around quickly? Who do you call to move positions? What sort of balance sheet does your prime broker have? Is it stable? Does it move?

And so I think people want to look at: How do I get access to my collateral if I have to move my collateral? What happens if my funding goes away? What do I need to do to liquidate a portfolio? How can I keep my portfolio stable? Really, just to minimize the impact on the funds’ investors, what are the things they can do in advance to work with the prime broker to make sure that, again, in case of an emergency, it’s just a more stable transition.

LYDIA TOMKIW: Any lessons from 10 years ago that you see potentially applicable today when thinking about this kind of planning?

MARK ALDOROTY: I think it really depends on what kind of fund you are and what sort of assets you trade. To me, top of mind is my liquidity provisions from my financing providers versus the liquidity of the portfolio. In other words, if you have a portfolio that can very easily be unwound or moved to another provider, that should give you some sense of ease.

On the other hand, if you have a much more longer-duration-to-maturity portfolio that may be harder to move or harder to finance or harder to unwind, you want to make sure you have funding in place, because you don’t want to be forced to do any sales. You want to make sure that the funding you have will be there to the extent that you can properly manage your portfolio.

I think years ago, too, because it was counterparty risk, understanding who your counterparty is and the strength of their balance sheet. And, not only what they’re lending you, but what do they do with their other clients? You might be somebody who doesn’t use that much leverage. If your financing counterpart or prime broker is offering up a lot of leverage to other people, that also exposes your prime broker to risks more systematic from other folks in the marketplace, rather than just what you’re doing with them.

Have an understanding of all the business of your prime broker, sort of an overarching—what do they do? What does it look like? What kind of leverage are they offering? Even though you might be a less-financed entity or vehicle, if they’re offering up 20 to one leverage to somebody else, that could ultimately impact you as well.

LYDIA TOMKIW: And what are the key questions that clients should be asking their hedge fund managers about all of this in preparations?

MARK ALDOROTY: I think if you were an investor in a hedge fund, you’d want to understand who your counterparties are, the stability of those counterparts, what could happen to your assets, where do the assets reside? Does your hedge fund manager know, in fact, what can be rehypothecated, what’s not being rehypothecated?

They also want to make sure of the kind of transparency and reporting could they get. Some investors may want to go into a commingled account, some may want to go into a separately managed account, and those give a different sort of outlook to the investor. They get a different level of transparency with each of those.

Understanding the risk metrics, understanding liquidity metrics and understanding where their collateral is, I think, are the key components.